Overview of Corporate Finance

FNCE 370v8: Assignment 2

Assignment 2 is worth 5% of your final mark. Complete and submit Assignment 2 after you complete Lesson 6.

There are 15 questions in this assignment. The break-down of marks for each question is presented in the table below. Please show all your work as this will help the marker give you part marks as well as serve as a good study aid as you prepare for the Final Examination.

Question    Marks Available    Reference
1    10    Lesson 2
2    5    Lesson 2
3    3    Lesson 2
4    8    Lesson 3
5    6    Lesson 3
6    6    Lesson 3
7    5    Lesson 4
8    10    Lesson 4
9    15    Lesson 4
10    5    Lesson 5
11    5    Lesson 5
12    5    Lesson 5
13    5    Lesson 6
14    5    Lesson 6
15    7    Lesson 6
Total    100

1. We have the following information for Athabasca Inc.              (10 marks)

Athabasca, Inc.
2010 Income Statement
($ in millions)
Net Sales                    $1,384
Less: Cost of Goods Sold                 605
Less: Depreciation                     180
Earnings before interest and taxes             599
Less: Interest paid                       80
Taxable Income                     519
Less: Taxes                         156
Net Income                    $   363

Addition to retained earnings        $   254
Cash dividends paid                     109

Athabasca, Inc.
12/31/09 and 12/31/10 Balance Sheet
($ in millions)
2009    2010        2009    2010
Cash    $   100    $   121    Accounts payable    $   400    $   350
A/R    350    425    Notes payable    390    370
Inventory    440    410         Total CL    $   790    $   720
Total CA    $   890    $   956    Long-term debt    500    550
Net fixed assets    1,556    1,704    Owner’s equity
Common stock    600    580
Retained Earnings    556    810

Total assets    $2,446    $2,660    Total liabilities    $2,446    $2,660

The firm has 180 million common shares outstanding. Calculate the following:

a.    Earnings retention ratio for 2010.
b.    The dividend to be paid (in dollars) in 2011. Assume Athabasca is projecting a 20% increase in sales for the coming year, and that cost of goods sold and general/administrative expenses remain a constant percentage of sales. Also assume that depreciation, interest paid, and the firm’s tax rate remain unchanged and that the firm’s dividend payout is 40%.
c.    Capital intensity ratio based on the 2010 results.
d.    Full capacity sales if Athabasca is currently operating at 70% capacity.
e.    External financing needed (EFN) for 2011 if Athabasca is projecting a 20% increase in sales for the coming year. Assume that assets, all costs, and current liabilities are proportional to sales but that long-term debt is not proportional to sales. Also assume that the firm’s tax rate remains unchanged and the dividend payout is 40%.
f.    External financing needed (EFN) for 2011 if Athabasca is projecting a 20% increase in sales for the coming year, with current assets, all costs, and current liabilities proportional to sales. Long-term debt is not proportional to sales.  Assume the firm’s tax rate remains unchanged, the dividend payout is 40%, and Athabasca is operating at 70% capacity.
g.    Internal growth rate for 2010 (assume the dividend payout ratio is fixed at 40%).
h.    Sustainable growth rate for 2010 (assume the dividend payout ratio is fixed at 40%).
2.    State the assumptions that underlie the sustainable growth rate and interpret what the sustainable growth rate means.                          (5 marks)

3.    Suppose a firm calculates its EFN and finds that it is negative.  What are the firm’s options in this case?                                  (3 marks)

4.    Fill in the blanks in the tables below.

a.    For each of the following, compute the present value (round answer to 2 decimal places).                                     (2 marks)
Future value    Years    Interest rate    Present value
543    10    13%
7620    13    6%
18054    15    4%
803851    6    31%

b.
For each of the following, compute the future value (round answer to 2 decimal places).
(2 marks)

Present value    Years    Interest rate    Future value
543    10    13%
7620    13    8%
18054    15    10.01%
803851    6    1%

c.    Solve for the unknown time period in each of the following (round answer to 4 decimal places).                                      (2 marks)
Present value    Future value    Interest rate    Time (years)
100    550    10%
2452    3000    13%
12463    234267    15%
139478    285736    9%

d.    Solve for the unknown interest rate in each of the following (round answer to 4 decimal places).                                      (2 marks)
Present value    Future value    Time (years)    Interest rate
100    550    10
2452    3000    13
12463    234267    15
139478    285736    9

5.    Suppose your firm is planning to invest in a project that will generate the following income stream: a negative flow $300,000 per year for 5 years, a positive flow of $450,000 in the sixth year, and a positive flow of $650,000 per year in
years 7 through 9.

What is the present value of this income stream if the appropriate discount rate is 10% for the first 3 years and 13% thereafter?                     (6 marks)

6.    Annuity A makes annual year-end payments of $976.50 for each of the next 10 years, while investment B makes annual year-end payments of $600 per year forever.
Show your work for the following two questions:                  (6 marks)

a.    At what interest rate would you be indifferent between the two investments?

b.    At interest rates above/below this break-even rate, which investment would you choose and why?

7.    A friend who owns a perpetuity that promises to pay $1,000 at the end of each year, forever, comes to you and offers to sell you all of the payments to be received after the 25th year for a price of $1,000. Assume an interest rate of 10%. Be sure to show your work.                                          (5 marks)

a.    Should you pay the $1,000 today to receive payments from the end of year 26 and onwards?

b.    What value would you be willing to pay?

c.    What does this suggest to you about the value of perpetual payments?

8.    Rob and Laura wish to buy a new home. The price is $300,000 and they plan to put 25% down. New Rochelle Savings and Loan will lend them the remainder at 8% per annum, compounded semi-annually for a 25-year term. The monthly payments are to begin in one month.                                      (10 marks)

a.    How much will their monthly payments be?

b.    Assuming they pay off the loan over the 25-year period as planned, what will be the total cost (principal + interest + down payment) of the house?

c.    What will the outstanding balance of the loan be after 10 years, assuming they make the first 120 payments on time?

d.    Suppose they want to pay off the loan in 15 years. How much extra must they pay each month to do so?

e.    Show the first six months in the amortization table for the 25-year mortgage.

9.    You are making plans for your retirement. You have just turned 30 and want to retire on your 65th birthday. At that time, you plan to move to the Caribbean, where you believe you can live comfortably on $200,000 per year. You also understand that inflation can impact your enjoyment of retirement so you would like the annual payments you receive to increase at a rate of 5% per annum. Your first payment of $200,000 will occur at age 66. You intend to live in the Caribbean until your 85th birthday, when you will receive your last installment from your retirement fund, move back to Canada, and freeload off your kids. You would also like to save enough money so that you can buy a new car when you are 35, and pay for a big retirement party when you are 65. You figure you will need to have $35,000 for the car and $10,000 for the party.
You estimate that you can earn an average return of 10% per annum on any money you invest over the next 60 years. You have just begun working and plan on saving $11,000 per year until you are 35 years old. You will make your first deposit one year from now. To ensure that you are able to achieve your objectives, you must first answer the following questions:                                  (15 marks)

a.    How much will you have to accumulate before you retire?

b.    How much will you have to save yearly, from your 36th to your 65th birthday, in order to accumulate the amount from part (a) and also pay for your retirement party?

10.    A bond is currently selling at 0.85 on its par value of $1,000. This bond has a maturity of 10 years and a coupon rate of 8%, payable semi-annually. If the inflation rate is 5%, what is the real yield on this bond?                          (5 marks)

11.    The bonds of Microhard, Inc. carry a 12% annual coupon, have a $1,000 face value, and mature in 4 years. Bonds of equivalent risk yield 10%. Microhard is having cash flow problems and has asked its bondholders to accept the following deal:

The firm would like to make the next three coupon payments at half the scheduled amount, and make the final coupon payment be $300. If this plan is implemented and investors still demand a 10% return, what will happen to the market price of the bond?
(5 marks)

12.    J&J Enterprises wants to issue eighty 15-year, $1,000 zero-coupon bonds. If each bond is priced to yield 9%, how much will J&J receive (ignoring issuance costs) when the bonds are first sold?                                  (5 marks)

13.    McGonigal’s Meats, Inc. currently pays no dividends. The firm plans to begin paying dividends in 3 years (at the end of t3). The first dividend at that time will be $1 and dividends are expected to grow at 5% per annum thereafter.

Given shareholders demand a 12% return on their investments, what is the price of the stock today (t0)?                                  (5 marks)

14.    Suppose that sales and profits of Oly Enterprises are growing at a rate of 30% per year. At the end of 4 years (t4) the growth rate will drop to a steady 5%. Oly recently paid a dividend of $1 per share. If the required return is 20%, what is the value of one Oly share today (t0)?
(Assume dividends grow at the same rate as earnings after year 4.)      (5 marks)

15.    Bradley Broadcasting expects to pay dividends of $1.12, $1.25, and $1.40 in one, two, and three years, respectively. After that, dividends are expected to grow at a constant rate of 5% forever (so, t4 to 8). Stocks of similar risk yield 12%.          (7 marks)

a.    What should the price of Bradley Broadcasting stock be today?

b.    What is growth rate of the Bradley Broadcasting dividend during year 2?

c.    How much is Bradley’s stock price expected to increase during the first year?

d.    What is the expected capital gains yield on Bradley Broadcasting stock during year 8?

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